HOUSING FINANCE SYSTEMS IN EMERGING MARKETS: AN OVERVIEW OF CURRENT ISSUES

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HOUSING FINANCE SYSTEMS IN EMERGING MARKETS
AN OVERVIEW OF CURRENT ISSUES
HOUSING FINANCE IN EMERGING MARKETS Policy
And Regulatory Challenges The World Bank March
2003

• 10TH March 2003

Bertrand RENAUD, Ph.D. brenaud_at_cal.berkeley.edu
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Agenda

1. World trends are now producing a massive latent
   demand for housing finance
2. Today, housing finance systems in emerging
   economies are often very small.
3. Strategies to develop mortgage finance systems
   are an integral part of overall financial
   development
4. The three core functions of mortgage finance
   systems are universal. System expansion depends
   on lowering the costs of these core functions.
5. There is no universally applicable model of a
   mortgage finance system. Each national system
   results form macroeconomic conditions, banking
   regulations, the structure of the banking system,
   taxation, subsidy programs and the organization
   of housing markets. These factors shape the path
   between bank-based and capital-market based
   mortgage loan delivery channels.

3
World population passed 6 billion at the start of
this third millennium
Billion
6.0

mid-1995 5.73 Billion
5.0
4.0
1975 4 Billion
3.0
1930 2 Billion
2.0
1850 1 Billion
1.0
1650 500 Million
200 Million
0
1 AD
500
1000
1500
2000
The World Almanac and Book of Facts 1996
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Urbanization creates a strong latent demand for
mortgage finance
International experience shows that a well
functioning mortgage market will provide very
large external benefits to the national economy

• - construction sector employment
• - efficient real estate development
• - easier labor mobility
• - capital market development
• - more efficient resources allocation
• - lowered macroeconomic volatility

5
In 1900, The UK had the only population that was
more than 50 urban
The invention of the amortized loan is of such
importance that it should rank with the
invention of the steam engine in changing the
face of Britain. A.A. Nevitt, Housing, Taxation
and Subsidies, 1966
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The world is now crossing the 50 urban threshold
and has passed the 6 billion mark
Over 50
Less than 50
Least urbanized
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Agenda

1. World trends are now producing a massive latent
   demand for housing finance
2. Today, housing finance systems in emerging
   economies are often very small
3. Strategies to develop mortgage finance systems
   are an integral part of overall financial
   development
4. The core functions of mortgage finance systems
   are universal. System expansion depends on
   lowering the costs of these core functions.
5. There is no universally applicable model of a
   mortgage finance system. Each national system
   results form macroeconomic conditions, banking
   regulations, the structure of the banking system,
   taxation, subsidy programs and the organization
   of housing markets. These factors shape the path
   between bank-based and capital-market based
   mortgage loan delivery channels.

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Housing finance depth Ratios of outstanding
mortgage loans to GDP (not scaled)
2. Middle East, 1999-2001
1. Latin America, circa 1998
4. Western Europe, 2001
3. East Southeast Asia, circa 1998
US 1998 53
EU-15, 2001 39
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FIRST AND FOREMOST macroeconomic stability is a
prerequisite
Macroeconomic volatility affects long-term
residential mortgage lending disproportionately.

• Recurrent episodes of macroeconomic volatility
  have a strong negative impact on housing finance
  systems. The experience of Mexico in the 1980s
  and 1990s illustrates a rather typical scenario
• high and volatile inflation implies very high
  real interest rates, which confines market-based
  mortgage finance to a fraction of the high-income
  population
• The government takes a dominant role in housing
  finance because of the widespread inability to
  afford mortgage finance and serious income
  inequalities
• The housing finance system remains small and
  becomes fragmented into uncoordinated and
  subsidized administrative programs
• Low level of domestic financial savings lead to a
  dependence of the housing finance system on
  central bank refinancing and/or international
  borrowings. CB refinancing and moral hazard
  problem can cause large quasi-fiscal deficits,
  which tend to perpetuate difficulties.
• RETURN TO STABILITY Mexico has regained control
  over its macroeconomic stability. Inflation and
  domestic interest rates have declined to levels
  not experienced in 15 years. As a result ,
  long-delayed structural changes toward an
  integrated market-based housing finance system
  are now taking place.

4Q-1993
BREAKDOWN OF LENDING RATES MEXICO, 4Q-1993
Source Glaessner Ochs, 1994
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SECOND Finance is a derivative of the real
economy (Andrew Sheng, 1999)
While all financial systems solve similar
problems, they solve them in different ways, and
any advice on financial policy and institutional
development must take the unique features of the
economic structure into account Millard Long,
2002
One must understand how local housing markets
operate. In some markets the share of informal or
extra-legal housing can be very large. In the
formal sector, three distinct policy dimensions
affect access to home ownership
1. The PRICE OF HOUSING UNITS relative to the
purchasing power of households is often measured
by the housing price-to-income (PIR) or
affordability ratio.
2. The TOTAL COST OF MORTGAGE BORROWING, which
includes (a) the all-in-cost of funding mortgage
loans, and (b) taxes and fees faced by borrowers.
EXAMPLE Citywide average housing price to income
ratios in selected capitals of the Middle-East in
2000. Source World Bank informal estimates
3. The STRUCTURE OF SUBSIDIES and the financial,
tax, regulatory and production channels through
which a government may subsidize some types of
housing -- explicitly or implicitly.
Markets where the PIR ratio rises above 5 face
serious demand and financing constraints and
higher default risks.
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THIRD Transaction taxes and fees can suppress
mortgage demand
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FOURTH In finance, small is seldom efficient
NETWORK EXTERNALITIES The more people use a
network, the more valuable it is for those who
are connected and the lower is the unit cost of
individual transactions

• With the information technology revolution, the
  core functions of a mortgage finance system
  benefit from large economies of scale.
• How common are small financial systems?
• 120 countries i.e. two out of three countries had
  an M2 (stock of money) under US 10 billion in
  1999, which is the size of a medium-sire regional
  bank in a developed market. These systems served
  800 million people.
• Out of those, 60 countries had M2 under 1
  Billion, which is the size of a small bank. These
  countries represent 200 million people.
• Small financial systems tend to be limited in
  scope, expensive and of limited quality. It is
  more difficult to diversify risks and to maintain
  liquidity. Regulation and supervision are
  expensive.
• The solution? Openness to external markets, and
  regional solutions can offset these drawbacks.
  But the risks of opening up the system must be
  carefully managed.

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AS A RESULT Cities are build the way they are
financed (B. Renaud, 1987)

• Commercial lending
• Diversified supply of housing units,
• Production completed in short amount of time
• Professional developers organized R.E. industry
• State financing
• Standardized, monotonous, low value units (high
  resource cost, low use value for the occupants)
• Inefficient industrial housing systems
• Elimination of the real estate and financial
  services professions leading to critical skills
  constraints
• Informal financing
• The visible outcome of policy and institutional
  failures
• Slow incremental housing based on retained
  savings
• Self-development by owners using small craftsmen

80 have access to formal finance
MEXICO Impact of past chronic macroeconomic
instability
54 informal housing
Access to housing finance services can vary
widely according to macroeconomic conditions,
banking systems, and the development of real
estate markets
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Most countries benefit from integrated reviews of
their housing finance system
A POLICY DANGER vicious circle of perceived
needs for large subsidies
Poor access to housing finance has
multiple consequences

• Negative impact on housing affordability
• Long delays in achieving home-ownership
• Protracted building periods developing cities as
  permanent construction sites.
• Inefficiencies in the development and use of the
  urban infrastructure
• Small, inefficient real estate industry
• Together these problems appear to contribute to a
  more skewed income distribution, i.e. a small
  middle class especially in volatile economies.

WHAT HOUSING FINANCE DEVELOPMENT STRATEGY ?

• THE LONG-TERM GOALS
• a low-cost, diversified
• mortgage finance system
• an innovative industry
• risks allocated to those best able to bear them
• a stable system resilient to economic shocks
• an organized, competitive housing industry

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Agenda

1. World trends are now producing a massive latent
   demand for housing finance
2. Today, housing finance systems in emerging
   economies are often very small
3. Strategies to develop mortgage finance systems
   are an integral part of overall financial
   development
4. The three core functions of mortgage finance
   systems are universal. System expansion depends
   on lowering the costs of these core functions.
5. There is no universally applicable model of a
   mortgage finance system. Each national system
   results form macroeconomic conditions, banking
   regulations, the structure of the banking system,
   taxation, subsidy programs and the organization
   of housing markets. These factors shape the path
   between bank-based and capital-market based
   mortgage loan delivery channels.

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Present changes in housing finance are part of
broader financial trends

• Changing role of the State
• Fiscal restraint for greater macroeconomic
  stability
• Economic and political decentralization
• Privatization to leverage scarce public
  resources
• More common non-state provision of public
  services
• Need to restructure subsidies and achieve better
  social policies
• Greater demand for transparency and
  accountability

• Structural changes in the financial sector
• Many forces are leading to a breakdown in
  inter-industry and inter- country barriers
  including financial innovation, technology,
  regulation and taxation
• Explicit focus of regulation and supervision on
  risk management
• Convergence toward international standards in
  accounting (IAS), banking (Basel II),
  insurance, securities market (IOSCO), valuation
  (IVSC)
• Renewed concern about governance

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Mortgage finance is an integral part of a
sustainable financial system
This financial environment determines the ALL-IN
COST OF MORTGAGE FINANCE (to be defined later)
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Major changes in financial markets since the
1980s have created a new environment
POST WW-2 DIRECTED-CREDIT POLICIES

• Leading government role in financial system
• Ceilings on interest rates on bank deposits
• High reserve requirement on banks
• Government directed bank credit
• Micromanaging banks, little autonomy
• Restrictions on entry, especially foreigners
• Restrictions on capital flows

Specialized housing finance circuits
FINANCIAL LIBERALIZATION since 1980s

• Relaxation of financial constraints
• Elimination of interest rate controls
• Lowering of bank reserve requirements
• Reduced interferences with bank
• management decisions (focus on risks)
• Privatization of nationalized banks
• Foreign bank competition
• Facilitation of capital inflows

Boundaries are breaking down Full integration
with overall financial system High rate of
innovation market deepening Systems more
resilient to shocks
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Innovations in the financial services industry
are also reconfiguring housing finance
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SUBSIDY REFORMS are on the critical path of
better housing finance systems
Four major reasons for housing finance subsidy
reforms are

• Fragmentation of the housing finance system and
  crowding out of private lenders by subsidized
  state-owned institutions and programs
• Negative impact on economic growth and
  stability when subsidies grow into a large share
  of GDP under macro-instability. International
  experience suggests that total housing subsidies
  above 2 of GDP are not consistent with
  stability.
• Negative effects on fiscal stability and
  budgetary efficiency when a high share of
  national housing budgets goes into large and
  poorly targeted financial subsidies
• Need to address better large or growing income
  inequalities

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The demand side of mortgage finance also shapes
the organization of the industry
The demand for mortgage finance Is both income-
and interest rate elastic. The range of housing
options is likely to vary across income groups,
which can lead to different market segments with
distinct institutional structures within the
national housing finance system.
WHAT MORTGAGE MARKET SEGMENTATION?
Bank-based or market- based system
without government support
Bank-based or market- based system with
some government support
Community-based Institutions. Microfinance
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Agenda

1. World trends are now producing a massive latent
   demand for housing finance
2. Today, housing finance systems in emerging
   economies are often very small
3. Strategies to develop mortgage finance systems
   are an integral part of overall financial
   development
4. The three core functions of mortgage finance
   systems are universal. System expansion depends
   on lowering the costs of these core functions.
5. There is no universally applicable model of a
   mortgage finance system. Each national system
   results form macroeconomic conditions, banking
   regulations, the structure of the banking system,
   taxation, subsidy programs and the organization
   of housing markets. These factors shape the path
   between bank-based and capital-market based
   mortgage loan delivery channels.

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THERE ARE THREE CORE FUNCTIONS TO ANY MORTGAGE
SYSTEM

• MORTGAGE ORIGINATION is the process through which
  mortgage debt is created. It is comparable to the
  underwriting function for other loans and capital
  market securities. 
• MORTGAGE HOLDING refers to the activity of
  institutions and other investors who own or hold
  mortgage debt. When the mortgage originator and
  the mortgage holder differ, it is necessary to
  transfer mortgage ownership. The high risk, high
  information costs, and small size of individual
  mortgages complicate the mortgage transfer
  process.
•  
• MORTGAGE SERVICING refers to a series of
  activities, including
• collecting the monthly payments from the
  borrowers and transmitting the funds to the
  holders,
• confirming that the borrower maintains property
  insurance and pays property taxes, and
• carrying out the foreclosure process in cases of
  default.
• These three functions are increasingly subject to
  large economies of scale

Liquidity risk Credit risk Interest rate
risk Prepayment risk
THE MORTGAGE HOLDING FUNCTION IS THE STRATEGIC
FUNCTION IN ANY MORTGAGE SYSTEM.
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1. CREDIT RISK can create costly loan origination
and servicing issues

• Land laws, civil codes, judicial systems,
  registries
• - Civil Law (Continental Europe, LAC)
• - Common Law (UK, etc..)
• Ottoman Law (Middle East)
• Legacy of Soviet laws and codes
• Customary laws

Localized/ on site forms of servicing
Alternative collaterals
Trust mechanisms of Latin America
1. Quality of property as collateral
Loan-purchase agreements
Loan origination and servicing
Mortgage Insurance Type 1 to remedy weakness in
titling and registration
LOAN-TO-VALUE RATIO (LTV)
2. Quality of valuation
Mortgage Insurance Type 2 Public or mutual
insurance aiming to to lower risks to marginal
income borrowers facing greater credit risks and
increase LTV as well. (Examples FHA in US, FGAS
in France). Mortgage Insurance Type 3
Commercial insurance Aiming to raise the LTV of
borrowers (Examples US PMI, British MIG)
LOAN PAYMENT-TO -INCOME RATIO (PITI)
3. Quality of income

• THE HOLY GRAIL
• RISK-BASED LENDING
• that can integrate operationally
• - Characteristics of the borrower
• - Mortgage design choice
• - Characteristics of the housing units
• Plus
• - private mortgage insurance?
• - public mortgage insurance?
• - family allowances?

Credit scoring and credit bureaus
4. Foreclosure alternatives
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2. LIQUIDITY RISK IS THE MOST IMMEDIATE
OPERATIONAL RISK
Mortgage loans create significant liquidity risks
for lenders Depositors in emerging economies
generally value liquidity--meaning the ability to
convert deposits rapidly to cash. Their
preferences reflect the high risks associated
with the macro economy, individual banks, and the
consumers individual needs for funds. Banks
must anticipate large and unexpected deposit
outflows, which require assets that can be
rapidly sold to finance these deposit outflows.
Government securities are good assets for this
purpose, since they can trade in active and
liquid markets and their prices are accurately
determined. The development of government debt
markets is an important externality to housing
finance, and to the banking sector more
generally. Business loans are more difficult to
sell, but their short-term maturities make them
essentially self-liquidating. Mortgages do not
have short-term maturities and they do not easily
trade in secondary markets because buyers find
it costly to verify the credit quality of each
mortgage offered for sale.
In the start-up phase of mortgage lending
deposit-taking institutions can rely on their
core deposits, but a limit on their portfolio
allocation to mortgage lending is soon reached.
Various market solutions exists, as will be
discussed during the conference.
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3. INTEREST RATE RISK is potentially very high,
and typically exceeds default risk

• Housing finance lenders are frequently short
  funded, meaning that the maturity (or duration)
  of their mortgage assets exceeds the maturity of
  their funding sources (such as bank deposits).
• Mortgage borrowers generally wish to match their
  durable housing assets with long-term mortgage
  loans. Depositors prefer the liquidity of
  short-term investments. Short funding creates an
  interest rate risk for the lenders since an
  increase in market interest rates raises the cost
  of deposits without immediately raising the
  return on the mortgage assets.
• In emerging economies, capital market instruments
  are unlikely to be available to hedge the
  interest rate risk, so floating-rate mortgages
  will be the norm. This means that borrowers
  face the interest rate risk, which increases
  their likelihood of loan default.
• - Adjustable mortgage instruments (AMIs) tend to
  convert interest rate risk into credit risk.
• Nominal and real interest rates (nominal
  interest rates adjusted for inflation) can be
  high and volatile, which further raises credit
  risk on AMIs.

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4. PREPAYMENT RISK is a concern for investors in
mortgage-related securities
Prepayment risks affect the all-in-cost of
mortgage finance. They are addressed through
financial instrument designs. They affect the
performance of a mortgage industry, but do not
play a strategic role in shaping the industrys
organization and structure
10-year lock (German Pfandbrief)
Pre-payment charges
Callable bonds
Consumer protection laws regulating or
prohibiting prepayments penalties can have a
significant negative impact on the all-in cost of
mortgage finance. Then what is the proper
horizontal equity across borrowers?
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The all-in cost of funding a mortgage loan is a
measure of total system efficiency

• Cost of mortgage functions
• Origination
• Holding
• Servicing

Private funding costs

• Government costs
• - Explicit (on budget)
• - Implicit (tax expenditures)
• - contingent cost of guarantees
• - Quasi-subsidies from state banks
• Administration of the mortgage system

Public costs

• The all-in cost can be seen as the opportunity
  cost of supplying mortgage finance for a given
  mortgage industry structure.
• The goal of public policies is to support the
  emergence of market instruments and institutions
  that will lower one or more components of the
  all-in cost of mortgage funding.

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Agenda

1. World trends are now producing a massive latent
   demand for housing finance
2. Today, housing finance systems in emerging
   economies are often very small
3. Strategies to develop mortgage finance systems
   are an integral part of overall financial
   development
4. The three core functions of mortgage finance
   systems are universal. System expansion depends
   on lowering the costs of these core functions.
5. There is no universally applicable model of a
   mortgage finance system. Each national system
   results form macroeconomic conditions, banking
   regulations, the structure of the banking system,
   taxation, subsidy programs and the organization
   of housing markets. These factors shape the path
   between bank-based and capital-market based
   mortgage loan delivery channels.

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Financial markets typically evolve from
BANKING-BASED to CAPITAL MARKET-BASED SYSTEMS
Source King and Levine, 1997
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The Pre-1980s, directed-credit environments
favored special housing finance circuits

• The historical origins of mortgage lending were
  local, mutual institutions emerging in developing
  financial systems British terminating building
  societies, permanent
• building societies, US Savings Loans, German
  Bausparkassen, Crédit différé, etc

Special circuits policies prevailed under the
Post WW-II directed credit environment. WHY?
The high all-in cost of mortgage lending by
depository institutions made this line of
business unattractive to commercial banks, so
governments encouraged specialized lenders
through a combination of restrictions and
privileges

• must maintain high percentage of loan portfolio
• in residential mortgage loans

restrictions
- special tax benefits - lower capital
requirements - can follow a short-funding
strategy
privileges
Non-diversified loan portfolios
short-funding strategy avoidance of
competition low-level of innovation fragility
under macroeconomic volatility
problems
The new financial environment has triggered many
charter conversions
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Today, DEPOSITORY PORTFOLIO LENDERS remain the
foundation

• Retail deposits lowest rate in the system
• Vertical integration of all mortgage functions
  no
• cost of transferring mortgages
• Informational advantages in credit evaluation for
  cross-lending with lowered information asymmetry

Advantages

• Financial costs of hedging interest risks under
  short-funding
• Regulatory costs (capital ratios, liquidities,
  reserves)
• and supervisory standards)
• Deposit insurance ?

Disadvantages

• lack of economies of scale in origination and
  servicing
• (Domestic impact of the IT revolution in
  information
• Processing and retrieving)

Private commercial banks in emerging economies
are natural starting points to develop the
housing finance system with their low-cost
deposits, expertise in lending, access to retail
customers. Access to capital markets permits
both these retail banks and finance companies to
expand their mortgage finance lines of business.
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CAPITAL-MARKET BASED mortgage finance is a major
structural change for the better
Major opportunities exist with the rise of
institutional investors in emerging economies -
pension reforms - insurance reforms -
securities market reforms - development of
mutual funds The growth of these potential
mortgage-debt holders is usually quite significant
But there are problems to solve with the sale of
existing residential mortgages - information
asymmetry on credit risk - unseasoned mortgages
and default several years later - mortgage loans
are small relative to investor portfolio scale so
that they cannot be individually evaluated
The three main ways to address the information
asymmetry problem - development of solid
underwriting standards - reputation of the
retail level mortgage originator - credit
guarantees

• Different solutions exist based on
• banking regulation, taxation finance industry
  legacies role of government private sector
  innovations
• Evolution of the all-in cost of mortgage finance
  (including government guarantees and other
  support policies)

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A great variety of mortgage market processes can
be observed around the world
Hold in portfolio
Depository institution originates loans
Issue mortgage bonds
Sell whole loans To investor
Investor
Sell loans
Secondary market institution or conduit
Pool loans into Mortgage backed securities
Sell MBS To investors
Non-Depository institution originates loans
Sell bonds to investors
Issue mortgage bonds backed by loans

• VARIETY OF LOAN ORIGINATORS
• A remarkable variety of loan originators can be
  observed today
• reflecting the diversity of national systems
• with significantly different all-in costs and
  degrees of overall efficiency

• EXPANDING INVESTOR BASE
• Public pension funds
• Private pension funds
• Life insurance companies
• Mutual funds
• Commercial banks
• Specialized lenders

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The EU-15 illustrates well the diversity of loan
originators and of system efficiency
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New housing finance policies need to be
consistent with other financial reforms
Macro-economic demand management
Fixed-income Securities Markets
Major focus on pension and insurance reforms
Retail Banking Consumer Finance Cross-Lending
- New subsidy designs - Market-focused
regulations - Restructured state institutions